Inflation - what is your view on labor slack?

Inflation is coming! Inflation is coming! 

Perhaps we should hold off with this view until we can answer some simple questions. All are focused on the same question of slack.

• Can we have sustained inflation if there is slack in the labor market?  
• Can we have sustained inflation if there is slack in factory capacity? 
• Can we have sustained inflation if there is an output gap?

There is agreement that inflation should move higher if we see these gaps start to close; however, it is not clear how much higher we can go beyond 2% if there is not a full closure of these gaps. Additionally, there is a question with defining what is slack. If workers are discouraged and leave the workforce, there can be a tightening of labor markets with lower labor participation. Perceived slack could be high but labor tight. 

Before you say anything about inflation tell me about your view on slack. 

For recent inflation numbers see Inflation - Not what was expected, not what is wanted.

To move to pre-COVID levels, we will need unemployment to fall by over 2.5%. 

To reach old capacity utilization levels, we need an increase of 2.5%.

Prices paid by service providers have almost reached the highest levels since the GFC and prices paid by manufacturers have moved back to 2018 levels.

Low volatility anomalies - Is it all about the skew?

There is no free lunch. The idea that you can form a low volatility portfolio and get added return or alpha is false once you take into account higher moments like skew. The low volatility or low beta portfolio is not so safe once you account for skew or tail risk. This idea is presented in the well-researched paper "Low-Risk Anomalies" in the October 2020 Journal of Finance. 

If an idea seems to be too good to be true, that is, you get return without having to pay for it with risk, then it is likely to be wrong. It is just a matter of trying to find the risk and figure out the pricing.

This paper concludes that the low risk anomalies are just compensation for coskewness risk, the risk associated with the asset and the squared market return. More important, ex-ante option-implied skewness is related to ex-post residual coskewness. There are tools or measures that can be used to find the assets that are most likely to be affected by coskewness. 

The option-implied skewness can be found in measuring OTM call and puts. If there is a skew in the options associated with a firm, there will be a meaningful coskewness that can account for the alpha in a simple regression of market risk beta. The alpha from a 3-factor and 4-factor model can also be described by this coskewness factor.

If an investor controls or accounts for this coskewness, there is no significant alpha for betting against beta or betting against volatility. Investor may think they are getting extra return by holding these low volatility portfolios, but it is a mistake. 

The argument has been that high beta portfolios are mispriced because of such issues as leverage constraints but this coskewness evidence seems more compelling. We have discussed the low volatility effect, see The low volatility style factor - A great history, but can it continue? and Low volatility / Low beta performance - This smart beta edge has been real, but we did not discuss the issue of skew as an explanation.

Skewness is an important risk potentially priced in the markets. This research highlights the problem of using only one dimension of risk, standard deviation. When investors say that they need to focus on tail risk, here is a perfect way to practically approach the problem. Look for how skewness is not priced in the market. This work does not mean that all low volatility investing should be avoided. It does mean that you are getting paid to take risk not associated with volatility. If you are comfortable with this skew risk, then take it. If you have not thought about it, then avoid the low-risk anomaly. 

David Ricardo - Cut those losses. Ride those profits!

I am not the first person who will comment on David Ricardo being a great speculator, but it is good to remember that basic principles of good money management have not just been discovered recently. There are few new secrets to good money management. Our math has gotten better, and we have learned some new tricks, but the basics have been in place for centuries. As long as there has been tradable markets and volatile prices, there has been speculation that has only been successful based on simple ideas like cutting loses and riding profits. 

For David Ricardo, he had two golden rules as noted by James Grant in his book, The Great Metropolis Volume 2. 

Ricardo made his wealth through being a stockjobber or specialist mainly in government consols, bonds. He often focused on arbitrage between the cash and more liquid forward market and some view him as an early quant.

A contemporary wrote of Ricardo: “He is said to have possessed an extraordinary quickness in perceiving in the turns of the market any accidental difference which might arise between the relative price of different stocks [government bonds].” His transactions would tend to be short-term and he would “realise a small percentage upon a large sum,” typically £200 to £300 a day. He wrote a friend, “I play for small stakes, and therefore if I’m a loser I have little to regret”. from "How David Ricardo Became The Richest Economist In History" by Mark Skousen

The civil servant John Lewis Mallet, who knew him well, wrote in 1823 that Ricardo “is said to have possessed an extraordinary quickness in perceiving in the turns of the market any accidental difference which might arise between the relative price of different stocks, and to have availed himself of this advantage, by selling out of one, and buying into another stock, or vice versa.”...Mallet added that Ricardo “is also said never to have carried his stock transactions to any speculative extent; but to have always, or generally, sold out on the turn of the market, so as to realise[sic] a small percentage upon a large sum.” from ECONOMIST DAVID RICARDO — ONE OF THE MOST SUCCESSFUL QUANTS IN HISTORY by Jason Zweig

Time tested risk management and trading rules have preceded most back-testing history used for analysis. Just follow the rules of great speculators. 

Postscript -

Ricardo was not above using information to game the market. A story from Paul Samuelson recounted by the great journalist David Warsh in "Paul Samuelson's Secret" describes Ricardo's skill. (The blog post from Warsh is an interesting history of Samuelson's speculation and the development of Commodities Corp.)

The bond trader had an observer stationed near the battle. Once the outcome was clear, he galloped quickly to where a packet ship was waiting. So Ricardo in London received the early news, and conveyed it to the British government.

Then he went down to his customary chair at the Exchange – and sold! Other traders, suspecting the worst, sold too, the prices of Treasuries tumbling, until at last, Ricardo reversed course and bought and bought and made a killing, his greatest coup ever, one that put even the Rothschild brothers in the shade.

“If not illegal, an ethical purist would have to fault Ricardo for in effect profiting from his own spreading false rumors,” Samuelson wrote. “In this millennium that might be something to criticize or even to litigate.” Even so, the ploy was not unheard of in the present day, he would confide, given that new news, not yet digested, was what sent markets spinning.

Rudi Dornbusch - How to think about the world of economics

 

Rudi Dornbusch -  “In economics, things take longer to happen than you think they will, and then they happen faster than you thought they could.”

There will be a lot research reports and thought pieces about what will happen in 2021. Some will discuss impending doom and others will focus on optimism, but most will not employ the key thinking from Dornbusch. For many of the big macro issues, we can see them coming, but the impact from any problem will take time. 

• Inflation
• Credit blow-ups
• Government dislocations 
• Stock market revaluations

These events are not black swans. These are grey or white swans representing known risks that will have to be faced, but with unknown timing. 

Policy-makers will do everything in their power to slow the inevitable; macro-prudential policies for the longer-run and liquidity injections in the short-run. We have seen a strong taste of this behavior in 2020. Monetary liquidity in many forms, aggressive fiscal policy, financial repression, and price manipulation were all employed. Why should we expect anything different in 2021? 

All policies will attempt to stop any economic pain and forego any destruction, albeit it is still happening though not immediately obvious. The impact from excessive policies will create new distortion that will have to be addressed through a new set of policies to solve the new problems. Think of the driver who overcompensates when starting to skid. There is no value judgment here other than issues will be pushed into the future until there is a catalyst that cannot stop swift repricing and adjustments. 

So, what can investors do? When reviewing forecasts, answer a simple set of questions: 

• What issues or problems are being expected?
• Why do we expect these issues to arise?
• When will they occur?
• What will be the catalysts to create these changes?
• What will be the policy and market response to these shocks?

You will quickly learn that all of these questions cannot be answered, yet much can be learned though working through the questions and possible scenarios. For some this may all seem obvious, but year-end makes for many proclamations with little support. 

Rudi Dornbusch was the great macro international finance MIT professor who influenced generations of economist. It is worth remembering his macro wisdom.